| Tax Talk |
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This week, as we all organize our W-2s & 1099s and field phone calls from accountants who are still in a good mood, we talk a little taxes.
Here’s a preview of the exciting territory we’re going to cover:
- How tax rates shift across the income spectrum.
- How much does the average household make and do you satisfy the criteria for wealthy? (some of you will be surprised!)
- Who’s really shouldering the majority of the tax burden.
- Who will have to pay even more in taxes?
- Are Democrats and Republicans really that divided on the subject of taxes?
Wealth and taxes are touchy subjects, so I’m sure this will send some of you into frothy rants. Let me hear it at Feedback@TheDraconian.com. I’d love to share some interesting reader perspectives in next week’s letter.
A (very) brief history of the income tax
The U.S. has a progressive tax system, which means that the more money you make, the more taxes you pay. This is true not just in an absolute sense, but also a relative sense. Unless you’re a really crafty bugger, you’ll pay a higher percentage of your income on taxes if you make $150,000 per year than if you make $30,000 per year.
This is the system we have today and have had since Woodrow Wilson reinstated the federal income tax in 1913. Under that legislation, pretty much everybody paid a marginal income tax rate of only 1% with the wealthiest ($10+ million per year in today’s dollars) paying as high as 7%. How great would that be, huh? And before that, there wasn’t even an income tax at all! Most of the government’s revenue came from tariffs on imports.
That would change in a hurry, however. By 1919 the U.S. had a war to pay for and at that point there were 57 different tax brackets. The top marginal rate was 73%. Again, most people paid only about 4% of their income in taxes, but that was a quadrupling from what it was earlier in the decade. Those rates came way down during the 1920’s, but by the time the next world war was on us, citizens were called upon to pay even more of their income in taxes. In 1945, most people paid between 25-35% of their income in taxes, and income above $200,000 was taxed at a mind-boggling rate of 94%. I made the mistake of looking at some of these historical income tax tables late one evening. It gave me nightmares.
I know a lot of you high-earners out there are losing sleep over Obama’s planned rollback of the Bush tax cuts, but maybe this will put things into a perspective. A bracket of 39% isn’t so bad in a historical context. And for all you others out there crying that the rich should pay for everything, keep in mind that folks in your bracket were paying about twice as much in taxes as you are today. During times of past crisis, all of our nation’s citizens had to step up and make sacrifices.
In the 1940s, we were on a gold standard so we couldn’t just print or borrow money to pay for things. If the government wanted to spend money, its people had to pay for it. Today it’s a little more complicated.
OK. A lot more complicated.
Who pays what
Here’s where we are today:
This charts the total effective tax rate for various income groups. It includes all the federal taxes that individuals pay: income taxes, Social Security & Medicare, and excise taxes.
The Bush tax cuts developed a reputation for unfairly benefitting the rich, but the middle class and poor were helped out even more. Given the economic and political environment we find ourselves in today, I think it’s easy to argue that, in retrospect, maybe those tax cuts weren’t such a great idea. Do we feel like we’re all in a better place today because of them? Did they make our lives and our nation better? Think about how great a tax cut of that magnitude would be in this current environment. Or how much real stimulus revenue of that magnitude could support. But all that ammo was spent to get one man elected and launch our nation into a lost decade of decadence.
Am I wealthy?
You’re probably wondering which bucket you fall into, so here’s how those quintiles above break down in terms of income:
| Lowest Quintile | $0 – $20,700 |
| Second Quintile | $20,700 – $39,000 |
| Middle Quintile | $39,000 – $62,700 |
| Fourth Quintile | $62,700 – $100,200 |
| Highest Quintile | $100,200+ |
A lot of you guys probably didn’t realize your household was in the highest or second-highest quintile. Those are households, too, so if you’re making $50,000 and your spouse is making $50,000, congratulations, you guys meet the statistical definition for “wealthy.” Or at least the wealthiest quintile. Do you feel wealthy?
Wealth can be a touchy subject, and there isn’t as much public discussion about it as there probably should be. Think for a moment about what would make you feel wealthy.
I had this conversation with many people during the middle financial crisis, and I listened to a lot of interesting, heartfelt responses. Wealth is a very personal thing to define, though common threads with those I talked to were an ability to satisfy basic needs without any worry and the ability to afford a modicum of luxury. I found it had less to do with money and more to do with security, comfort, and freedom. I count myself lucky to know and have known people who are technically in the lower and middle quintiles but consider themselves wealthy. And I’m also glad I know many others, well into the highest quintile who do not consider themselves wealthy. Perspective is a valuable asset, the reason I court diversity in my body of friends and colleagues.
Back to statistics, care to venture a guess what kind of income places you in the top 5% of wage earners? That eeevil top 5%, the extremely “rich” that needs to pick up the slack, “pay their fair share”, and shoulder an even greater portion of our collective income tax burden?
$180,000.
Don’t get me wrong, if this is you, you’re doing well, but it’s probably not what you thought of when you think of those that are richer than 95% of the rest of us.
Let’s break it down. $180k gross is about $126k net under average assumptions. Us lucky Nevadans don’t have to pay state income tax, so for most of you that “top 5% paycheck” is closer to $110-115k. That’s about $9,500 per month. That should responsibly support a $450,000 house, a nice SUV and a sedan. It’ll pay for utilities and school supplies for your kids and maybe a nice vacation or two per year. You can eat out when you want, but certainly not all the time. If you have no other financial obligations in life like a business to feed or a wayward sibling to support, you might also be able to squirrel away a few thousand dollars to invest. Odds are, if this is you, you probably aren’t even maxing out your and your spouse’s IRA contributions.
Is it the good life? You bet. But it’s not a mansion-on-the-golf-course and a membership-at-the-club rich. And obviously, if you live in a major metropolitan area like New York City or a state like California, that $180k doesn’t get you quite as far. That might be “middle class” in some locales.
Again, that’s household income. So maybe you pull down a decent living in finance, and your wife works for the state. Maybe your wife is an attorney and you run a small computer business. Maybe you’re a doctor. You’ve got loans and a house and a car, and a wife that takes care of the kids who, before you know it, will be on their way off to college. Do you feel really rich? Do you feel like you’re not paying your fair share? What do you say to those who demand you contribute even more of your hard-earned income to keep the nation solvent?
If this is you, how do you feel about those that both earn and pay less than you do?
And what if this is not you? What if you struggle from paycheck to paycheck? Your family budget probably can’t handle more taxes. How do you feel about this guy living the good life, but who is probably also living right at or very close to his means? Do you tell him to sell his house for something more modest and swap his SUV for an economy car? Does he have an equal right to demand that you lease a smaller apartment and trade that Camry in for a used Kia?
These are very personal questions. There are no right answers. But they’re important considerations when it comes to macroeconomic policy, something that’s ultimately funded by a nation of diverse individuals.
Who’s really shouldering the tax burden?
The rich. Mostly.
But you knew that.
We can have debate about whether or not this should be the case in the another venue. Is it the responsibility of the rich to shoulder a larger burden, to pay for most of the cost of benefits that are consumed primarily by others, many of whom pay nothing to enjoy them? Or is it the responsibility of each of us, regardless of our level of income, to pay an equal relative share of the benefits that we all enjoy together? This is a classic debate and I have heard good arguments for both schools of thought. But as I said, that’s a conversation for another forum. Today we’re just going to focus on facts, on what is.
The fact is that those who make more money pay for a bigger share of our country’s expenses. They do it in absolute terms and they do it in relative terms.
I know we’re only talking about income taxes here, and tax revenue does come from other sources. But it’s not a lot.
Taxes on corporations make up about 10% of federal revenue, and excise taxes on stuff like gasoline and cigarettes account for less than 5%. Most of it is income tax and social insurance tax, which is based on income. The government gets most of its money from taxing its individual citizens.
Here’s the nitty gritty of who pays what:
Unless you’re a data hound like me, your eyes probably just glazed over. Hopefully you weren’t reading this in bed.
It’s a lot to digest, I know.
Don’t worry, I’ll give you the juicy bits:
Those of you with an adjusted gross income of $100,000 per year or more, which is about 16% of all tax returns received by the IRS, account for nearly three-quarters of all the income tax revenue generated. Those of you making less than $50,000 per year, which is about about half of all returns that get filed, account for only 10% of total income tax receipts.
You’ve probably heard that the top 5% of wage earners account for about half of all the income tax revenue that gets collected, and this is true. But did you know that those of you that make more than $10,000,000 per year, a scant 0.017% of all returns, account for nearly 10% of all the income tax revenue that gets collected?
Despite the fact that a relatively small percentage of higher-earning individuals pay for the overwhelming majority of total tax revenue, it apparently isn’t enough:
Gallup has been asking this question for a while now, and apparently, most people think that the wealthy have never paid their fair share:
It’s hard for the wealthy to complain about this (you know, ‘cause they’re wealthy), but this makes me wonder just how much is enough? It’s an interesting question to meditate on.
Here’s a chart of the highest marginal income tax rate:
Before Reagan took office and slashed taxes – a historically correct moment at which to lower taxes, I should add – the average top marginal rate for most of the century was 79%.
I wonder if middle class folks in the early 1950’s – a time when the top marginal rate was 92% – still felt that the wealthy weren’t paying their fair share. I wish I had some pre-1980 polling data. (feedback@thedraconian.com if you guys ever find any neat data sets – I eat this stuff up.)
Anyway, today the top bracket is 35% and set to revert back to 39.6% in 2011. I’d be shocked if that isn’t even substantially higher by 2020. This is an easy, politically palatable way to raise revenue, especially in this era of stark partisanship:
The current administration has already decided that curbing spending is not an option for the decade to come. Therefore, the government needs to look at new ways to generate revenue to prevent these deficits from spiraling too far out of control. If you think that large deficits and a large debt-to-GDP ratio are things we shouldn’t be concerned about, you haven’t read Reinhart & Rogoff’s This Time is Different: Eight Centuries of Financial Folly. I’ve been talking about this book since last year, and today, everywhere I turn I hear another sophisticated voice in the industry talking about it as well. This is a seminal book. Just don’t read it late at night.
The bottom line is that we’re in a real pickle and the menu of politically feasible solutions is slim. Higher marginal rates is one, and I think a VAT (value added tax), which I covered in our Predictions for 2010, is another. 2010 is too soon to see either of those materialize, but I think this is the year that the dialog picks up, especially if economic growth strengthens.
Now that we’ve covered what’s happening on the income side of Uncle Sam’s statement of operations, it’s time to take a look at what’s happening on the expense side.
Where does my money go?
Charts are always a nice way to answer questions like this:
It’s pretty simple.
Most of your money goes to four places:
- Social Security
- Healthcare
- National defense
- Interest on our debt
Does the rest of it even warrant being talked about? Probably not. At least not today. There’s a lot of noise about all the social programs and agencies and pet projects that the government has, but in the grand scheme of things it just doesn’t matter. Don’t get me wrong, these programs may be really important (if you directly benefit from them) or wasteful spending (if you don’t). But when we look at the dollars and cents of the big picture they don’t really move the needle.
This is actually part of the problem. Tell me if you haven’t had a similar exchange in line at the grocery store:
Me: mmm… orange Tic Tacs.
Tic Tacs: Yes, you liiike orange Tic Tacs.
Me: Do I really need orange Ti-
Tic Tacs: -YES! We are only $0.79.
Me: What the heck, they’re only $0.79 and so delicious!
When it comes time to tighten the federal budget, the little expenditures are the first to get scrutinized. That’s fine and all, but instead of worrying only about all the orange Tic Tacs I’ve purchased, I should really think about swapping filet mignon for hamburger every so often. OK, sirloin. A fair compromise, steak snobs?
Now imagine a nation of 300 million people who have elected 575 individuals to make thousands of decisions on their behalf. Not only are these guys constantly adding little expenditures here and there, but when it comes time to clean up the budget, these tiny expenses are the only things that actually get reduced. When it comes to the big stuff like entitlement spending all we get is rhetoric.
I might be a card-carrying libertarian (which in certain circles wins me immediate dismissal from the conversation) but I’m not too far gone into the land of every-man-for-himself ideals that I can’t assess the big picture without a bit of pragmatism. It wasn’t that long ago that I was in college, a time when knowing how to navigate pockets of honest-to-God socialists was an essential tactic for social survival.
Imagine for a moment that you lived in a country where you had to pay for your own healthcare and save for your own retirement.
Would our society be better or worse off?
(You don’t want to imagine life in the U.S. without such a military. The military gets kicked around a lot and often for good reason, but the reality is that the United States is the United States because of its military. No other factor comes close to enabling all that a dominant military can. I’m a fan of diplomacy too, but the world I live in is one where muscle is might. Whether I like it or not.)
What would the government do with a few extra trillion per year in revenue? Or how would individuals’ lives be different with dramatically lower tax burdens? What kind of new business would that environment attract? I’m not saying we should eliminate these programs completely, but these are interesting questions that can lead you in different directions on the political spectrum.
These are great programs, but you’ll see in a moment that we’re in a bit of a bind.
Closing the gap
Here’s the chart that will give you nightmares tonight. Those with delicate constitutions should scroll ahead.
Seriously, look at that chart again.
Let it soak in for a moment.
What unnerves me the most about this chart is how long it’s been since we’ve spent what we made. What kind of example does our government set for individual households? Or, does the government spend more than it makes because it’s composed of individuals who do the same? There’s a mindbender for you.
Note that increases in spending tend to quickly follow increases in revenue. Given what you know about politicians, that shouldn’t surprise you. As soon as they get a little money they spend it.
Perhaps that problem isn’t unique to just politicians, but rather Americans in general. If there’s a way for us to spend money and get a little enjoyment in the present, we’ll do it, regardless of the long-term costs & consequences. Right or wrong, this is way most of us are wired. There are good reasons for that but that’s more the domain of psychology. Though as the field of economics evolves, the line between those two disciplines blurs.
You’ll notice that chart really starts to diverge in the early 70’s, and you astute historians are probably smiling right now with the answer as to why. In 1971 the U.S. said goodbye to Bretton Woods and since then, without a gold standard to keep us honest, deficit spending has been the norm. Our government talks a lot about “pay as you go”, but you can see that they just aren’t wired to act in that way and there’s no monetary system in place to force them to.
Right now, the politically feasible solution seems to be to increase taxes on unpopular groups like the rich or the banks and cut (cut?!) taxes on everybody else. As we pointed out last week, the wealthy already pay most of the taxes in this country anyway, it’s just that the threshold for “wealthy” is a little lower than you probably guessed. I hear a lot of talk from the current administration about cutting taxes and a lot of talk about protecting or increasing benefits. Does nobody else recognize the unsustainability of that equilibrium?
That chart is the reality with which we are faced. An era of sacrifice has begun. Some will be sacrificing more than others, but all of us will need to chip in eventually.
In one way or another.
The truth about the tax code and the “inflation tax”
I mentioned that the tax code is incredibly complicated. The reason it’s so complicated is that it is used as a tool to shape social behavior. You don’t have to venture very far into the land of behavioral economics to discover that individuals respond to incentives, particularly financial incentives. And so tax breaks here and penalties there have the effect of changing certain behaviors that the government believes are in our collective interest.
Ultimately, the tax code is also a tool that politicians use to get elected. Voters like to elect politicians that promise them things, especially money. So the tax code gets amended and amended again to give certain freebies to certain folks, and the result is the 4 million word behemoth we have today.
Most taxpayers aren’t too affected by all the mumbo jumbo the IRS has published, but there is a sneaky tax that lives outside the tax code that everyone pays and no one can dodge: inflation.
You might be wondering how on earth the U.S. is going to reconcile that chart of diverging revenue and spending. It isn’t socially feasible to rely on tax revenues to get the job done. Contrary to popular belief, the government isn’t actually stupid. It knows it can’t just raise taxes on its people without political consequence. But here’s the clever solution: it borrows money to fuel spending right now and then pays back its lenders in the future with dollars that are less valuable than they were when the government lent them. The dollars are less valuable because there’s a lot more of them floating around.
You might not realize it but inflation is a hidden “tax” that we all pay. The government recaptures a few extra percent of our dollars every year via the monetary policy that it has chosen to adopt. If I put $1,000 under my mattress in 1900 and took it out today it would still be $1,000. The difference is that when I put it under my mattress it was an entire year’s salary and today it’ll buy me one month’s payment on my 4Runner and a robot vacuum. (This is the future, after all.)
What happened to that magnificent loss of purchasing power? It was inflated away but the powers that be.
Inflation gives us an incentive to consume, to exchange dollars for services, plasma TVs, and other stuff. It’s also an incentive to invest, to find riskier assets that return more over time than cash does.
The Fed slashed rates to less than 0.25%. It has purchased mortgage-backed securities and treasury bonds, forcing down interest rates to historically low levels. I can go out today and buy 1-year T-bills that yield about 0.3%. Inflation in 2010 will probably clock in somewhere north of a couple percent. My return after inflation is negative2-ish percent. Why on earth would I do this? Why would I make an investment where I am guaranteed to lose money after adjusting for inflation?!
It’s nuanced discussion, but if you’re a normal person the answer is that you don’t do this. You run out and buy the stock market or higher-yielding corporate debt instead. Or maybe you spend it on a robot vacuum. This is exactly what Bernanke, Geithner, Obama, China, OPEC, and pretty much everybody else in the world wants you, the American Consumer, to do.
Maybe you’ve heard theories about how Alan Greenspan inadvertently created the housing bubble by keeping rates too low for too long. Maybe you’re wondering why the stock market rallied so much last year. Maybe you feel antsy about holding too much cash. Negative real interest rates may not have been the sole reason for those phenomena, but they were extremely powerful contributors.
Think about how you might rebalance your portfolio if your savings account paid you 3 or 4%. Imagine if 10-year treasuries nabbed you 5 or 6%. Think that’d be good or bad for riskier investments like stocks or real estate?
Rich or poor, every single one of you knows the answer to that question.
What to do about it
Our goal here at The Draconian is to be entertaining, informative, and useful. I haven’t a clue if we’ve been entertaining but I feel pretty confident that we’ve been informative. Now, here’s the “useful.” Here’s what you can do about all of this.
Buckle up for higher taxes.
You high earners out there really need to strap in and get your financial house in order. Focus on controlling the spending side of your personal income statement. There’s actually a wonky term out there to describe this phenomenon, “Ricardian equivalence”, a fancy-shmancy way of saying that if people are expecting to get taxed more down the road, they’ll save more today.
Those of you who aren’t high earners also need to get your expectations in line. The rich are an unpopular minority at present and it’s normal for them to be targeted first in an environment like this. But there are hard limits on the size of the burden they can shoulder, and soft limits on the point at which they begin to change their behavior in socially inefficient ways. It’s reasonable to expect that given the fiscal policy the U.S. will be forced to run during the next decade, the wealthy minority will not be able to do it all themselves.
Lower-earning households should prepare for sacrifices as well. For you guys it probably won’t come via a higher income tax rates, but it could through higher social security rates or more excise taxes. Lower-earning households benefit disproportionately from social welfare programs, and a slashing of entitlements is the way that those folks will probably have to sacrifice. Don’t be surprised to see your healthcare, state pension, or Social Security benefits scaled back. If you’re in one of those lower income quartiles that we talked about last week and you’re relying on government cheese to support your lifestyle, you will need to make some adjustments. At the very least, align your expectations appropriately.
I’ve talked about a VAT before on here, and this is a real discussion that needs to take place in Washington in the years to come. These types of taxes are considerably less progressive than the income tax. That’s a fancy-shmancy way of saying that they impact the poor the most.
In time, everybody will feel the effects of inflation as well. There are ways to avoid the “inflation tax,” but you have to be clever and read awesome newsletters like The Draconian. By virtue of reading a newsletter like this one, you guys get a substantial leg up on your peers (I’m not joking).
I frequently mention books and other blogs in this space, and these are other resources that will help you out in your battle to survive the challenges of today and tomorrow. Check them out. If you think a static page of books and blogs that we recommend would be beneficial, let me know at Feedback@theDraconian.com and I’ll put something together.
The virtue of saving
Remember that the number one rule in nasty recessions is conserve cash. Everybody loses in ugly environments like this. The winner is he who loses least, and he who loses least is usually the guy who had the most cash.
I know you’re all saving aggressively, but now it is even more important to do so. You need to save in such a way that taxes and inflation don’t wipe you out. Make sure you’re maximizing contributions to tax-deferred accounts. When you’re investing, make sure you incorporate inflation-sensitive assets like Gold and TIPS into your portfolio.
Work with a skilled accountant (or use TurboTax like Tim Geithner!) to make sure you aren’t paying more than you should and are taking advantage of all the weird incentives the tax code has given you. I don’t understand all this IRS stuff and it changes every year, but that’s what I pay my accountant for.
I have a pretty good feel for the demographics of our readership. I know that this letter goes out to a disproportionate percentage of high earning, high net worth individuals. I’m sure a few of you others out there were surprised to discover “Hey! I’m actually wealthy!” So I hope what we’ve touched on in the last two weeks are some issues and questions that aren’t being discussed in more mainstream venues.
And I hope I haven’t left the rest of you behind. You may not have gigantic investment portfolios, but you have a unique advantage over your peers; you are intelligent readers. Keep reading and someday you too will find yourself in the wealthy bucket – for better or worse!
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